From Conservation

During California’s recent drought, the utilities that own their supply sources conserved more than the those that purchase water from wholesale suppliers

-Warning: this post contains hardcore wonkery-

A while ago I blogged about my ongoing work with Youlang Zhang and David Switzer on water conservation in California. The first of our studies is now published at Policy Studies Journal; more are on the way. There we saw that financial incentives and institutional politics led to the surprising result that private, for-profit companies out-conserved local government utilities during a recent drought.

But another interesting pattern emerged from that study: a significant difference in conservation between utilities that draw their water supplies from wholesale sources.

Where utilities get their water

The drinking water utilities that serve American communities get their water in one of three ways*:

1) Pumping groundwater from wells that tap underground aquifers;

2) Drawing surface water from lakes and rivers; or

3) Purchasing water from a wholesale water utility.

In the first two cases, local utilities own wells, surface water intakes, and treatment plants. About 29% of American utilities fall in the third category, getting their water through wholesalers. In these cases, the local utility owns a distribution and/or storage system, but the supply works and perhaps the treatment facilities belong to another utility. Sometimes these wholesale utilities have retail customers of their own, sometimes they are purely wholesale suppliers.

Spreading the risk

A major advantage of big wholesale water utilities is that they allow a region’s water supply to be managed holistically and comprehensively. Rather than individual communities competing and depleting water supplies, regional wholesalers can plan and balance water supply needs. From the local perspective, wholesale utilities help diversify supply and so guard against catastrophic supply shortages. They also allow communities across a region to pool their capital for greater efficiency. Together these features spread both supply risk and financial risk across many local utilities.

“Take-or-pay”

Sales agreements between retails and wholesalers vary widely across the country, so generalizing is difficult. But one common feature of wholesale contracts is the take-or-pay provision. Under take-or-pay arrangements, the wholesaler agrees to supply and the retailer agrees to purchase a fixed volume of water over a given period of time for a given price. If retail demand exceeds the contract volume, the retailer pays for more on a volumetric basis. If retailer demand falls short of the contracted volume, the take-or-pay provision requires the retailer to pay the wholesaler anyway, as if it had used the entire contract volume.†

In other words, under take-or-pay contracts, the retailer pays the wholesaler the same amount, even if the retailer uses far less water than the contracted volume.

Wholesale supply & the logic of conservation

Got all that? Still with me?

Here’s what it all means for conservation. Wholesale supply arrangements reduce supply risk and long-term financial risk to local utilities. Take-or-pay contracts make a lot of sense for long-term stability for supply systems that have high fixed costs.

But in the short-term, these wholesale arrangements create disincentives for retail conservation during a drought. Under wholesale agreements, short-term supply risk from drought is shifted from the local utility to the wholesaler: the wholesaler is legally responsible for maintaining adequate supply. Meanwhile, fixed take-or-pay contracts leave retailers on the hook for the same amount no matter how much water their customers actually buy. The retailer may suffer significant sales declines if it rains all summer, or if the state imposes drought restrictions, but the retailer still has to pay the wholesaler as if demand was normal.

Wholesale $avings

Does diluting risk also dilute conservation? As I explained in an earlier post, the recent drought in California prompted that state to impose conservation rules on retail water utilities from June 2015-May 2016. Each utility was assigned a specific conservation target and the state recorded overall conservation by each utility.

Did utilities that operate under wholesale supply arrangements perform differently from utilities that own their own supplies?

Our analysis of data from the drought mandate period is pretty striking. After accounting for a host of organizational and environmental conditions, we found that water systems that rely on wholesale water supplies were 42% less likely to meet state conservation standards, compared with systems that own their own supplies.

We also found that, after accounting for other factors, utilities under wholesale contracts conserved an average of 2.6% less each month relative to systems that use their own wells or surface water sources. In a state as large as California, this small percentage difference equates to tens of billions of gallons.

Follow the money

These patterns don’t prove that wholesale contracts caused California utilities to slack on conservation. But the data certainly align with the short-term incentives that wholesale supply arrangements create, and there aren’t other obvious reasons for the disparity. The lesson here is to pay close attention to wholesale contracts when setting conservation rules, so that conservation and financial incentives work in concert.

*Technically there are other sources, too—desalination and water reuse, for example–but they’re so rare that they don’t allow for much meaningful analysis.

†”Take-or-pay” is a weird phrase, since there’s really no “or” to the arrangement. Seems like “fixed fee” is a more accurate label, but then I’m not a lawyer.

Why rate structures, not assistance programs, offer the most promising path to water affordability

When discussions of water and sewer affordability turn to policy solutions, they typically focus on Customer Assistance Programs (CAPs). But a focus on CAPs bypasses a much more direct, effective, and efficient means of improving affordability: rate design. To see what I mean, consider the way we combat infectious diseases.

Therapy vs Inoculation

Clinical therapy and inoculation are both ways to fight infectious diseases. Each approach can improve health, neither is perfect, and some combination of both is useful in practice. But for the most serious diseases, inoculation is far superior to therapy.

Not cheap

Clinical therapy is costly. For therapy to cure a disease, a patient must recognize that (s)he is sick, be aware that treatment is available, seek treatment, and then follow a course of treatment and hope that it works. For health care providers, therapy requires highly skilled employees, careful diagnostic procedures, and treatment that can involve expensive drugs and equipment. Meanwhile, the broader community bears the costs of people who go untreated or carry the disease without symptoms.

Inoculation is comparatively inexpensive. Inoculation requires little time or sophistication from patients, and it is quick and easy for health care providers. A tiny minority might suffer adverse effects, but the community benefits from widespread immunization, which can sometimes effectively eradicate a disease from an entire population.

Customer assistance programs as clinical therapy

CAPs seek to ameliorate affordability problems caused in part by water and sewer rates. CAPs come in lots of shapes and sizes. Some are as simple as shut-off forbearance and budget billing; others involve income-qualified rate discounts or bill forgiveness plans; still others provide high-efficiency fixtures or appliances for low-income households.

Like clinical therapy, CAPs are costly. CAPs have obvious direct costs to the utility, like revenue lost through discounts or the direct cost of installing retrofits. CAPs can also have significant administrative costs: someone must determine which customers qualify, keep records of who receives or is denied assistance, and keep track of those who lose eligibility over time. Utilities sometimes coordinate assistance with other agencies to administer these programs more efficiently, but that only reduces administrative costs, it doesn’t avoid them. CAPs can be politically and legally risky, too, since they are explicit transfers from one group to another. In many states utilities are legally constrained from such transfers.

Less obviously, CAPs are also costly for their recipients. In order to participate in a CAP, a water customer must:

Learn that the program exists;

Find out if (s)he is eligible;

Apply for the program; and

Follow up with program administrators as necessary to maintain eligibility.

Each of these steps imposes a transaction cost of time and effort on working-class families. If participation requires an in-person visit, then transportation and child care add to those costs. Language barriers and distrust of government can raise transaction costs even further. There are good reasons to believe that many people who are eligible for and badly need CAPs never apply for them.

Rate design as inoculation

Some key elements of rate design can improve affordability directly, without the need for CAPs, by maintaining low prices for essential household water and sanitation. Specifically, affordability-friendly rate structures feature:

Like inoculation, rate design is a solution with low administrative burdens. Affordability-friendly rate designs create no additional transaction costs for utilities or customers. Since rate structures apply to everyone, there’s no need to determine or track income eligibility, and there’s no worry that eligible customers are failing to sign up. Customers do not need to learn about, apply for, or document their eligibility. Rate design isn’t an affordability cure-all, but it can go an awfully long way toward immunizing a population against unaffordable water and sewer service.

So why don’t more utilities use rate design to address affordability?

Ordinary organizational inertia is one reason, of course. There’s also a widespread misperception in ratemaking circles that affordability contravenes goals like cost-of-service equity, full-cost pricing, and/or conservation. Happily, affordability-friendly rate design can exist in harmony with all of these principles—I’ll tackle that topic in a future post.

But the greatest barrier to more affordability-through-rate design is probably revenue stability. High fixed charges generate revenue reliably. Revenue from volumetric charges fluctuate with water sales, which vary seasonally and can skyrocket or plummet depending on the weather. A utility doesn’t sell much high-priced, high-volume water if it rains all summer and nobody waters their lawn. That can leave the utility in tough financial shape, because the utility’s capital and operating costs are mostly fixed. Some utilities have responded to falling average water demand by raising their fixed charges, in large part to manage revenue volatility. That’s bad news for affordability.

So a key to more affordable rate design is developing mechanisms that manage utilities’ revenue risks. Adequately insulated from those risks, utilities can price water more equitably, efficiently, and affordably.

Many California communities restricted outdoor irrigation during the recent drought. Did enforcement matter?

Bad water boys, watchya gonna do when they come for you?

Faced with water scarcity, communities sometimes restrict residential outdoor water use, such as car washing and especially lawn/garden irrigation. These water restrictions are effective in driving water conservation, and many California communities adopted them during that state’s recent drought (I’ve blogged about them before). The severity of those restrictions varied considerably, with some utilities allowing unlimited irrigation, some allowing irrigation just one or two days per week, and a few banning outdoor irrigation altogether.

Enforcement of those restrictions was up to individual utilities, and enforcement actions varied considerably. Youlang Zhang and I have been analyzing those enforcement actions and how they correlated with conservation outcomes; we’ll present our first results at the APSA Conference in Boston next week. How did California utilities enforce water restrictions? Did enforcement actions affect water consumption?

Avenues of enforcement

In July 2014 the SWRCB authorized local water utilities to impose fines of up to $500 a day for violating water restrictions and invited citizens to report violations of water use restrictions through online portals and telephone hotlines. After receiving complaints or observing violations, utilities proceeded with a series of escalating enforcement steps. The first is a follow-up action, an informal intervention that typically involves sharing information with the violator with a goal of compliance through education. The second step is a formal warning, where the utility informs the violator of regulations and potential penalties. The final step is a formal penalty and fine.

A different logic underlies each of these enforcement actions Follow-up actions convey information about public policies and community values, with the expectation that greater awareness will motivate conservation. Warnings threaten violators with punishment, and so raise the prospective cost of profligacy. Penalties punish past action in hope of deterring future behavior. Over the course of the drought local utilities issued hundreds of thousands of warnings and levied tens of thousands of penalties for violating water regulations.

Enforcement effects

We analyzed monthly data from California over the 32-month drought emergency period, looking for relationships between utilities’ enforcement actions and total conservation by those utilities. Basically we were asking: does past enforcement predict present conservation?

Initial results are fascinating. Informal follow-up actions and penalties had no statistically discernible relationship with conservation. Only warnings appear to be correlated with conservation. Here are the effects, plotted graphically:

Marginal effects of enforcement action on conservation

In substantive terms, these results indicate that 100 formal warnings results in about 0.1% greater conservation. Though these figures are small in percentage terms, they represent potentially large volumes of water. An average of 500 more warnings each month during the observation period would have reduced the state’s total water consumption by 29 billion gallons—enough to supply the City of San Francisco for 15 months.

So are penalties pointless?

Does that mean that penalties don’t work? Not necessarily. It’s likely that the positive effects of warnings depend on the threat of penalties. Also, a $500 penalty might be an insufficient incentive for conservation in utilities where penalties were imposed. If you’re a rich celebrity, you might not care about a $500 fine enough to stop wasting water. Without detailed data on individual violations (which we don’t have), it’s hard to say.

In any event, the effects of all enforcement actions were apparently short-lived. Enforcement actions were most influential early in the drought emergency, when climatic conditions were most severe. As the drought weakened, the influence of enforcement also declined. The effects of all three types of enforcement actions appear to be negligible in the long run.

Lessons for conservation

We need to do more work to make sure we have the analysis right and to tease out all of the temporal effects, but our findings to date suggest three preliminary takeaways:

Formal warnings are most effective in driving overall conservation; and

Warnings can lead to immediate conservation during an emergency; but

Enforcement effects decline in the long run, and so probably don’t help promote conservation as a “way of life.”